Oil’s Roller Coaster Creates Cheap Options

by Tyler Craig | October 10, 2012 11:53 am

Tuesday’s trading session unleashed a barrage of selling that spilled into virtually every sector on Wall Street. Led by continued weakness in Apple (NASDAQ:AAPL[1]), tech stocks bore the brunt of the selling, with the Nasdaq Composite falling 1.5% before being saved by the closing bell.

Interestingly, a few areas escaped the bearish onslaught unscathed. Crude oil beckoned the few surviving bulls to its quarters and cobbled together an impressive 2.9% rally. Not surprisingly, the strength in oil buoyed energy-related stocks, causing the sector to capture the top spot for the day’s sector performance.

Click to EnlargeThe recent action in oil has led to some interesting developments in volatility. Since plumbing new yearly lows at 12% in early September, 20-day historical volatility (blue line in chart) in the United States Oil Fund (NYSE:USO[2]) has risen to 33%. Though it’s a bit more erratic, 10-day historical volatility (white line) has lifted to 38% over the same time frame.

The escalation in movement has lifted both measurements of realized volatility above implied volatility (red line), which is an infrequent occurrence that makes options on USO appear somewhat cheap.

The $64,000 question is whether you expect the recent volatile action in the price of USO to persist. If so, traders should take advantage of the relative cheapness in USO options by going long volatility in some fashion. While traders with a directional bias could simply buy calls or puts, those looking for a more pure play on volatility could enter an October “strangle” by purchasing the Oct 35 call and the Oct 34 put for a net debit of 94 cents or better.

The strangle is a bi-directional trade that benefits from a large price move in either direction as well as a lift in implied volatility. When managing a strangle position, some traders use a passive approach where they sit tight until either a profit target or stop loss is reached. For a profit target I would consider exiting at a 10% to 20% profit, which would occur if the strangle rose in value by 10 cents to 20 cents.

As for a stop loss, traders might consider exiting if the strangle falls in value by more than 50%, which would occur if the strangle dropped from 94 cents to around 45 cents.

At the time of this writing Tyler Craig had no positions in any of the aforementioned securities.